Eddie Vedder and the Japanese carry

Just like everyone else in the financial markets over the last week or so I have become the world-famous specialist on Japanese flows (!)*. I have heard a lot of more or less plausible stories and when I was trying to digest all the noise, I couldn’t help but think about “Nothing As It Seems” by Pearl Jam:

Occupations overthrown, a whisper through a megaphone
It’s nothing as it seems, the little that he needs, it’s home
The little that he sees, is nothing he concedes, it’s home
And all that he frees, a little bittersweet, it’s home
It’s nothing as it seems, the little that you see, it’s home…

Jeff Ament, Pearl Jam

I am not certain what is going to happen with the wall of money that is seemingly coming from Japan, but I know that there’s a remarkable amount of superficial analysis, which I would like to comment on.

1. The Japanese carry trade will continue as the BoJ prints more.

According to estimates by Daiwa net issuance of JGBs after stripping BoJ purchases will be -26trn yen. This is around 5% of GDP, which is a pretty monstrous amount. This naturally makes people’s imagination go into overdrive, particularly as we’re talking about the country with decent carry-trading history. But there is one problem with such an approach. Carry trade was Japan’s response to the lack of returns in the local market. Bond yields have been ridiculously low and the stock exchange was still suffering as zombie-banks kept dragging it (and the economy) lower. Now, do you think this situation has not changed even a bit? We may be agreeing or disagreeing with what the BoJ is doing but investors (particularly retail) could be excused for e.g. thinking that the Nikkei will double this year. This is particularly the case as what the BoJ seems to have orchestrated is a fantastic opportunity for the Japanese banks to cash in on their available-for-sale JGB portfolios. So answer yourself this question – is it so entirely obvious that Mrs Watanabe continues buying AUDJPY (annual yield of 3.2%), ZARJPY (annual yield 5.4%) or MXNJPY (annual yield 4%)? Granted, these and many other currencies will continue to constitute a very important part of the Japanese investment portfolio but pretending that the investment backdrop in Japan has not changed is naive in my opinion.

2. The big yen move has only just begun.

Currently various forecasters are trying to come up with the most bearish view for the yen. I have already seen 120/USD but admittedly I do not pay much attention to that stuff. But try to think who has so far made money on the yen debasement? If you don’t know then try to get a hold of the HSBC hedge fund report to see that the vast majority of macro funds have caught at least a part of this move. And because selling the yen is seemingly such a no-brainer**, not being in the trade is a big career-risk for many. In some sense, macro hedge funds cannot afford to miss another leg in the yen move (if there is one). But in the greater scheme of things this is just noise. Don’t forget that the Japanese economy has just become at least 30% cheaper. And we are talking about a bunch of historically deadly innovative companies who have managed to keep their place in the global market place against all odds.

Goldman has recently produced a study showing that the country with the most similar exports composition to Japan’s is… Germany. It is already very much visible it the underperformance of the DAX, in my opinion. Personally I prefer Mercedes over Toyota but at a 25% discount I know I would change my mind.

My thinking is as follows: if this yen depreciation and the crowding out of the Japanese banks from the JGB market is persistent then Japan has every chance to become the champion of the global trade again. And if so, why on earth would I be buying GBPJPY or AUDJPY?

Let me give you another example: If you have been selling the yen and buying the South African rand consistently in the last five years then only last week did you break even on your average spot level. Sure, you got some coupons in between but it cannot be ruled out that investors who have been buying the ZAR against the JPY will just take this as an opportunity to close the position after being bailed out by the BoJ.

3. Banks will invest abroad.

This bit I find preposterous. I have mentioned above that banks may have just been given a lifeline by the BoJ and they will be able to off-load their available for-sale portfolios at a significant profit. What they do with the cash next is anyone’s guess but banks are not really in the business of punting on currency markets with their balance sheets. Believe it or not but even when GS recommends buying EURUSD, it’s not like Goldman’s treasury shifts all its money to Europe. Banks operate in the “LIBOR+” world. They are happy to take exposure to foreign bonds but it is usually done on an asset swap basis. Below are a few bonds that I just looked up on Bloomberg and how they compare when swapped to JPY.

  • T 2 02/15/23                                     78bp
  • SAGB6.75 03/31/21 #R208       68bp
  • MBONO6.5 06/09/22                    68bp
  • POLGB 4 10/25/23                          10bp
  • TURKGB8.5 09/14/22                   36bp

As you can see those differences are not huge and definitely not big enough to make emerging markets irresistible. Additionally, there’s a perverse effect of what’s been going on in the JGB market lately. The chart below shows a crude calculation of VaR for 10y JGB futures since 2000.

JGBVaR

A chart of the yield volatility is looking even scarier, which – paradoxically – could bring the Japanese banks into a risk-reduction mode as no one can bear such wild swings of the profit and loss account. And adding Brazilian assets to the portfolio doesn’t help much.

4. Asset managers, insurance companies and pension funds will invest abroad.

Yes they will. The same way as they have in the past. Well, maybe with a bit bigger size but it’s far from being certain at the moment. If it’s the yen weakness they’re after then I suppose buying the USD will do (without adding an extra layer of volatility between the USD and some other currency). And if they don’t think the yen weakens much from here then why would they accelerate foreign buying in the first place?

This brings us to the last point I would like to make. As much as in previous years the Japanese investments abroad were driven by expectations of superior returns outside of the country, we are now talking about the expected yen weakness. In my opinion this changes the structure of investors taking advantage of the move and I believe that it will be the foreigners shorting the yen, rather than the locals. This, at least in the near term, makes it a tactical, rather than a structural trade.

So these were my views on the whole situation. I don’t have any concrete recommendations this time but I just don’t like how one-sided the discussion has become. And if I’m wrong then… well… listening to Eddie Vedder while writing this post definitely made it worth my while.

* not sure how to stress that I am being ironic, but I have noticed that subtitled movies on Sky have (!) at the end of sarcastic sentences.

** I have always thought that no-brainers are for people without brains but somehow this definition hasn’t become mainstream.

Be careful what you target or am I in the right church?

So the G20 damp squib is behind us and while many commentators will say that it has given a “pale green” light for the likes of the BoJ to keep devaluing their currencies, I think the whole discussion is somewhat flawed.
Here’s why.
Devaluing one’s way out of trouble seems to be a very convenient solution to most crises. It’s as if producing and selling stuff to other nations was the ultimate reason to live. But devaluation can have many different forms, which some people find confusing.
To explain that let’s actually look at something that hasn’t been discussed for a while, i.e. revaluations and real convergence. It is quite common sense that small, open economies tend to converge to income levels of their richer trade partners. The mechanism usually works through significant inflow of know-how followed by a boost in productivity, particularly in the tradable goods segment. Subsequently, the Balassa-Samuelson effect kicks in and we have a generalised increase in the price level. Usually this is accompanied by appreciation of the currency. Both those factors – higher inflation and a stronger currency – lead to appreciation of the Real Effective Exchange Rate. We have seen such a mechanism in a lot of emerging economies, e.g. in Central and Eastern Europe after the EU entry in 2004.
Note that the two factors at play (nominal exchange rate and inflation) are interchangeable and work together to balance the system. In other words, if for some reason inflation in the country in question is artificially depressed, the nominal exchange rate will move more.
Now let’s go back to devaluations. There are two broad reasons why a country would like to weaken its currency:
1) to boost exports,
2) to increase the money supply.
This distinction matters because without that how could we explain behaviour of such countries as Japan, Switzerland, Czech Republic or Israel? These economies have traditionally excelled at exports due to superior growth rates in productivity in the tradable goods sector. Yet, those countries have engaged in significant operations in the foreign exchange market in recent years (or threatened to do so). Note, however, that in each and every case it was preceded by bringing interest rates close to zero. Therefore, we should conclude that FX operations were just an extension of monetary policy after traditional ways (i.e. interest rate cuts) have been depleted. As a result, saying that these central bank have engaged in currency wars is pretty daft, in my opinion.
Now, there is a group of countries, which probably would like to see their currencies weaken to improve the competitiveness. However, if this is an objective then we must discuss the real exchange rate. And the standard economic theory dictates that it can only be done via increase in government savings.
Let’s take the most recent example of a country, which seems to be trying to pursue such a goal. The Central Bank of the Republic of Turkey has been stressing the importance of the REER lately. They even outright threatened that they would intervene in the FX market should the 120 level be broken. There is a fundamental flaw in this logic, though.
To start with, Turkey is a country with a very high current account deficit, which basically means that its domestic savings are relatively low. By extension, consumption is fairly high thus keeping inflation rather elevated. In such an environment, selling the lira (TRY) makes very little sense as it will most likely boost inflation even further, offsetting the paper (aka nominal) gains. This brings us to a paradox that higher inflation leads to higher REER thus necessitating monetary policy easing. In my home country of Poland we have a saying that “they can hear a bell toll, they just don’t know at which church”. Similarly here – the CBRT has correctly identified the problem of having to boost competitiveness but they have chosen a dangerous approach.
Instead, the government should increase its savings even more than it already has to bring total domestic savings higher, thus increasing competitiveness. This way, it can avoid persistently high inflation and current account deficits.
This is not to say that such a recipe is great for everyone. It would’ve been good for, say, Spain before the crisis but now the focus should be more on the nominal side of the equation. Such examples could be multiplied.
But what I’m trying to say is beware of people talking about currency wars any time they see a central bank intervening in the FX market because you will miss the important distinction between the nominal and the real sides of things.
And policymakers, be careful what you target because you can end up at a wrong church.

PS. I wrote this post on “yet another on time Ryanair flight” so there are no links or anything. I will try to update those tomorrow with a few interesting articles on the subject.